Sunday, July 27, 2008

Week of May 26, 2008--Real Estate's Future

“The future ain’t what it used to be,” said Yogi Berra, famously. So how can we even hope to predict future housing activity? Certainly we know several factors that helped to inflate the real estate bubble—record low interest rates and deregulation of the financial markets that allowed for rampant manipulation of securitized mortgage credit ratings, among others.

And we know that regulators are now overreacting as property values continue to decline, so that higher credit scores and larger down payments are now required for most purchase and refinance transactions, even with verified incomes.

But we also know that both existing and new-home sales have stabilized somewhat. Annualized existing-home sales have been in the 5 million unit range for the past 6 months (4.89 million in April from 4.94 million in March), while new-home sales just jumped 3.3 percent in April.

One comparison is the last housing recession—which lasted from approximately 2001 to 2006, before prices returned to prior levels. But banks were dropping like flies then due to the S&L debacle, and the Federal Reserve wasn’t much help. In fact Alan Greenspan, et. al., began raising interest rates in 2004 without much warning, causing Orange County’s bankruptcy, for one.

The Fed is playing a different game this time, injecting all kinds of money into the system by holding as collateral many of those prime and subprime mortgage-backed securities that banks haven’t been able to unload.

The Fed has also lowered their over night rate 3.25 percentage points since last fall, bringing the Prime Rate down to 5 percent and the indexes that control adjustable rate mortgages much lower.

This has flooded the financial markets with money, raising fears of higher inflation down the road. Be that as it may, inflation has always helped property values. Also, Fed Governor Janet Yellen believes the Fed’s “liquidity-enhancing” actions “are having a beneficial effect on financial markets”.

Reinforcing Yellen’s optimism is that first quarter Gross Domestic Product growth was just revised upward to 0.9 percent from 0.6 percent, mainly because of higher export growth. Its so-called PCE inflation index that the Fed uses also was lower. In fact the core index without food and energy prices was up just 2.1 percent in Q1 and is up just 2 percent in a year.

But perhaps the best gauge of housing values is the so-called housing price-to-rent ratio. It is the ratio of a home’s value over annual gross rents. Its national average is currently 25 times annual rents, according to the San Francisco Federal Reserve Bank, meaning that a home that rents for $30,000 per year is now worth approximately $750,000. Its long-term average since 1970 is about 21.5, which means that average prices may decline another 14 percent. But values could fall even further, of course, since the price-to-rent curve is not a straight line, but fluctuates around its average value.

So what is the future for both housing sales and values? Sales of new and existing home will probably stay in the same narrow band this year, simply because for sale inventories are bloated by newly foreclosed homes replacing those that were sold.

And values will eventually return to the long-term 21.5 housing-to-rent ratio average. This ratio has taken 10 years to return to its historical ratio over each of the last 2 housing cycles—from 1980 to 1990 and 1990 to 2000. This is of course unless the future “ain’t what it used to be”!

© Harlan Green 2008

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